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Introduction:
Thinking Like an Economist
CHAPTER 2
CHAPTER 13
12
1
Perfect Competition
There’s no resting place for an enterprise
in a competitive economy.
— Alfred P. Sloan
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Perfect Competition
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Chapter Goals
 Explain how perfect competition serves as a reference
point
 Explain why producing an output at which marginal
cost equals price maximizes total profit for a perfect
competitor
 Determine the output and profit of a perfect competitor
graphically and numerically
 Explain the adjustment process from short-run
equilibrium to long-run equilibrium
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Perfect Competition
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Conditions for Perfect Competition
• A perfectly competitive market is a market in which
economic forces operate unimpeded
• For a market to be perfectly competitive, three conditions
must be met:
1. Both buyers and sellers are price takers – a price taker is a firm or
individual who takes the price determined by market supply and
demand as given
2. There are no barriers to entry – barriers to entry are social, political,
or economic impediments that prevent firms from entering a market
3. Firms’ products are identical – this requirement means that each firm’s
output is indistinguishable from any other firm’s output
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Perfect Competition
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Profit Maximizing Level of Output
 The goal of the firm is to maximize profits
• Profit – the difference between total cost and total
revenue
 A firm maximizes profit when marginal revenue equals
marginal cost
 Marginal revenue (MR) is the change in total revenue
associated with a change in quantity
 Marginal cost (MC) is the change in total cost associated
with a change in quantity
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Perfect Competition
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Marginal Cost, Marginal Revenue, and Price
Graph
Marginal
Cost
P
MC = P
$35
MC > P,
decrease output to
increase total profit
P = D = MR
MC < P,
increase output to
increase total profit
Q
MC = P at 8 units,
total profit is
maximized
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Perfect Competition
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Profit Maximizing Level of Output
 The profit-maximizing condition of a competitive firm is:
 MC = MR
 For a competitive firm, MR = P
 A firm maximizes total profit, not profit per unit
If MR > MC,
• a firm can increase profit by increasing output
If MR < MC,
• a firm can increase profit by decreasing its output
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Perfect Competition
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Marginal Cost, Marginal Revenue, and Price Table
Price = MR ($)
Q
35
0
35
1
35
2
35
3
35
4
35
5
35
6
35
7
35
8
35
9
35
10
Marginal Cost ($)
28
20
16
14
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The profit-maximizing condition
of a competitive firm is:
MC = MR = P
If MC < P,
increase production
Profit maximizing
quantity is where MC = P
22
30
40
If MC > P,
decrease production
54
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Perfect Competition
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The Marginal Cost Curve is the Supply Curve
Marginal
Cost
P
=
Firm’s Supply
Curve
$70
Because the marginal cost
curve tells us how much of
a good a firm will supply at
a given price, the marginal
cost curve is the firm’s
supply curve
$61
$35
For example, if market price
is $19.50, the firm produces
6 units.
$19.50
$13.00
4
6
8
10
Q
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Perfect Competition
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Profit Maximization using Total Revenue and
Total Cost
 An alternative method to determine the profit-maximizing
level of output is to look at the total and total cost curves
• Total cost is the cumulative sum of the marginal
costs, plus the fixed costs
• Total profit is the difference between total
revenue and total cost curves
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Perfect Competition
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Total Revenue and Total Cost Table
Q
Total Revenue ($)
Total Cost ($)
Total Profit ($)
0
0
40
-40
1
35
68
-33
2
70
88
-18
3
105
104
1
4
140
118
22
5
175
130
45
6
210
147
63
7
245
169
76
8
280
199
81
9
315
239
76
10
350
293
57
Total profit is
maximized at 8
units of output
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Perfect Competition
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Total Revenue and Total Cost Table
Total Cost,
Total Revenue
TC
TR
Max profit = $81
at 8 units of output
The total cost curve is
bowed upward at most
quantities reflecting
increasing marginal cost
$280
$175
$130
Losses
Losses
Profits
3
5
The total revenue curve
is a straight line
8
Q
Profits are maximized
when the vertical
distance between TR
and TC is greatest
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Perfect Competition
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Determining Profits Graphically: A Firm with
Profit
P
Find output where
MC = MR, this is the
profit maximizing Q
MC
MC = MR
P
ATC
Profits
ATC
P = D = MR
AVC
ATC at Qprofit max
Qprofit max
Q
Find profit per unit
where the profit max Q
intersects ATC
Since P>ATC at the
profit maximizing quantity,
this firm is earning profits
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Perfect Competition
Determining Profits Graphically:
A Firm with Zero Profit or Losses
P
Find output where
MC = MR, this is the
profit maximizing Q
MC
ATC
Find profit per unit
where the profit max Q
intersects ATC
Since P=ATC at the
profit maximizing quantity,
this firm is earning
zero profit
MC = MR
AVC
P
=ATC
P = D = MR
ATC at Qprofit max
Qprofit max
Q
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Perfect Competition
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Determining Profits Graphically: A Firm with
Losses
P
Find output where
MC = MR, this is the
profit maximizing Q
MC
ATC
ATC at Qprofit max
ATC
P
AVC
P = D = MR
Losses
MC = MR
Qprofit max
Q
Find profit per unit
where the profit max Q
intersects ATC
Since P<ATC at the
profit maximizing quantity,
this firm is earning losses
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Perfect Competition
Determining Profits Graphically:
The Shutdown Point
 The shutdown point is the
point below which the firm
will be better off if it shuts
down than it will if it stays
in business
 If P>min of AVC, then the
firm will still produce, but
earn a loss
 If P<min of AVC, the firm
will shut down
 If a firm shuts down, it still
has to pay its fixed costs
P
MC
ATC
AVC
PShut
P = D = MR
down
Qprofit max
Q
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Perfect Competition
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Short-Run Market Supply and Demand
 While the firm’s demand curve is perfectly elastic,
the industry’s demand curve is downward sloping
 The market supply curve is the horizontal sum of all
the firms’ marginal cost curves
 The market supply curve takes into account any
changes in input prices that might occur
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Perfect Competition
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Short-Run Market Supply and Demand
Graph
P
P
Market
Firm
MC
Market
Supply
ATC
P
P
ATC
P = D = MR
Profits
Market
Demand
Q
Qprofit max
Q
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Perfect Competition
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Long-Run Competitive Equilibrium
 At long run equilibrium, economic profits are zero
 Profits create incentives for new firms to enter,
market supply will increase, and the price will fall
until zero profits are made
 The existence of losses will cause firms to leave the
industry, market supply will decrease, and the price
will increase until losses are zero
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Perfect Competition
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Long-Run Competitive Equilibrium
 Zero profit does not mean that the entrepreneur does
not get anything for his efforts
 Normal profit is the amount the owners would have
received in their next best alternative
 Economic profits are profits above normal profits
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Perfect Competition
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Long-Run Competitive Equilibrium Graph
P
At long-run equilibrium,
economic profits are zero
MC
LRATC
SRAT
C
P = D = MR
Q
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Perfect Competition
Market Response to an Increase in Demand
Graph
P
P
Market
Firm
MC
S0(SR)
P1
P0
S1(SR)
2
1
2
S(LR)
1
D1
1
2
Q0 Q1 Q2
D0
ATC
P1
P0
SR Profits
1
2
1
2
Q
Q0,2 Q1
Q
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Perfect Competition
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Long-Run Market Supply
 If the long-run industry supply curve is perfectly
elastic, the market is a constant-cost industry
 If the long-run industry supply curve is upward
sloping, the market is an increasing-cost industry
 If the long-run industry supply curve is downward
sloping, the market is a decreasing-cost industry
 In the short run, the price does more of the adjusting,
and in the long run, more of the adjustment is done
by quantity
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Perfect Competition
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Application: Blockbuster
 The owners of the Blockbuster chain of video rental
stores had to close over 2,000 of its stores after
experiencing years of losses.
 Initially, Blockbuster saw the losses it was suffering
as temporary because P>AVC
 But after years of losses, Blockbuster recognized
that prices had fallen below these long-run average
costs.
 Since in the long run all costs are variable, the ATC
became its relevant AVC. At that point, it shut down
those stores for which P < AVC .
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Perfect Competition
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Chapter Summary
 The necessary conditions for perfect competition include:
buyers and sellers are price takers, there are no barriers
to entry, and firms’ products are identical
 The profit-maximizing position of a competitive firm is
where marginal revenue equals marginal cost
 The supply curve of a competitive firm is its marginal cost
curve. Only competitive firms have supply curves.
 To find the profit-maximizing level of output for a perfect
competitor, find that level of output where MC = MR
 Profit is price less average total cost times output at the
profit-maximizing level of output
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Perfect Competition
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Chapter Summary
 In the short run, competitive firms can make a profit or
loss. In the long run, they make zero profits.
 Graphically, profit is the vertical distance between the
price of the good and the ATC curve at the maximizing
level of output times that level of output
 The shutdown price for a perfectly competitive firm is a
price below average variable cost
 The constant-cost industries have horizontal long-run
supply curves. Increasing-cost industries have upwardsloping long-run supply curves, and decreasing-cost
industries have downward-sloping long-run supply
curves.
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